The conduct of monetary policy in a diverse monetary union

Summary:
The monetary union of the euro has been established between very diverse countries. In itself, diversity is a positive feature, since variation in comparative advantages enables more risk sharing and gains from enhanced trade (Alesina and la Ferrara 2005). Yet European countries also differ in terms of institutional quality. This difference is well-appreciated by the general public and dominates the discussion in public media.1 What are the consequences of a monetary union among diverse countries?2
Definition of institutions
In economic research, “institutions” refer to essential ‘rules of the game’ – explicit and implicit governance structures that shape how public policy and private contracting actually works (North 1991). They may differ from formal institutions as they reflect the actual allocation of decision power, and are critical to understanding comparative economic performance across countries (Acemoglu et al. 2005).
Better institutions ensure a reliable contracting environment and safe property rights, increasing private efficiency in the private sphere. In the political sphere, greater accountability ensures that public decisions are more aligned to social welfare and less captured by special interests, reducing waste and ensuring proper competition.

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The monetary union of the euro has been established between very diverse countries. In itself, diversity is a positive feature, since variation in comparative advantages enables more risk sharing and gains from enhanced trade (Alesina and la Ferrara 2005). Yet European countries also differ in terms of institutional quality. This difference is well-appreciated by the general public and dominates the discussion in public media.1 What are the consequences of a monetary union among diverse countries?2

Definition of institutions

In economic research, “institutions” refer to essential ‘rules of the game’ – explicit and implicit governance structures that shape how public policy and private contracting actually works (North 1991). They may differ from formal institutions as they reflect the actual allocation of decision power, and are critical to understanding comparative economic performance across countries (Acemoglu et al. 2005).

Better institutions ensure a reliable contracting environment and safe property rights, increasing private efficiency in the private sphere. In the political sphere, greater accountability ensures that public decisions are more aligned to social welfare and less captured by special interests, reducing waste and ensuring proper competition. Delays in enforcing contracts increase costs and economic uncertainty, and can undermine funding in difficult circumstances. These differences help explain the procyclicality of capital inflows between Northern and Southern Europe (Jaccard and Smets 2016).

Historically, firms in countries with weaker institutions faced higher transacting and fiscal costs, resulting in reduced incentives to invest and decreasing competitiveness over time. Weak institutions are leading causes of underdevelopment and financial instability (Acemoglu et al. 2003). These countries relied on periodic exchange rate adjustments to restore their trade balance. As a result, other countries suffer as devaluations disrupted their own productive decisions.3

Institutional differences across European countries are far less pronounced than those between developed and developing countries. All members of the EU are democracies that profess full allegiance to the rule of law. Yet there are evident differences in the quality of political governance and the effectiveness of legal enforcement.

Excess public spending is a common result of poor public governance, and results in tight borrowing constraints. Countries with weak institutions (henceforth, “weak countries”) are unable to raise international funding in domestic currency, and their foreign exchange borrowing is quite limited.

Thus, countries with weaker institutions resort more often to devaluation as a necessary element of flexibility in difficult times, but because of their structural inefficiencies their gain in comparative advantage is temporary.

In contrast, countries with better political governance (“strong countries”) achieve a higher quality of public spending are able to maintain a higher exchange rate, as lower public spending and its efficiency supports larger net savings and thus a positive trade balance.

With these elements in mind, in a recent paper, Matteo Crosignani, Bauke Visser and I study the working of a commitment to a common exchange rate among countries with different institutional quality (Crosignani et al. 2016). Next to the well-understood effects of exchange rate commitment, we also identify a general equilibrium effect, which is quite important for interpreting the working of a diverse monetary union.

A monetary union clearly offers a direct gain for stronger countries, as their productive activities do not suffer from devaluations by weaker member countries. Critically, the benefit increases in joining up with very diverse countries that require frequent or larger devaluations.

A monetary union also strengthens the financial credibility of weak member countries, improving their access to credit. This occurs for two reasons. First, the nominal value of weak country debt is now more stable. Second, repayment is more certain in case of major shocks as investors recognise that maintaining the monetary union in difficult times may imply some burden sharing. This explains the minimal sovereign bond yield difference between weak and strong Eurozone countries ahead of the crisis.

These two effects are well known. But what is the general equilibrium effect of a diverse monetary union?

We show that in the absence of fiscal centralisation, governments in weaker countries that join a diverse monetary union will choose to increase public borrowing. As a result, although a monetary union has a positive effect on growth, it may induce greater fiscal stress in difficult times. Since these countries are no longer able to devalue, the survival of the monetary union will require some cross-support in stress times.

Fiscal transfers are naturally unpopular, and there may be calls for a strong country to secede from a monetary union to avoid what appears to be an undeserved subsidy. Yet it appears that the greater political pressure for exiting the euro comes from voters in weaker economies. My co-authors and I suggest that a third, more subtle effect can well explain the resilience of a diverse monetary union, namely, its general equilibrium effect on the external exchange rate. A diverse monetary union ensures a structural productive advantage for strong countries, since a common exchange rate will be more favourable than their self-standing exchange rate. In fact, the more diverse the monetary union in terms of institutional quality, the larger the exchange rate appreciation for weak member countries and the depreciation for strong members.

Intuitively, a monetary union between more and less disciplined governments has the effect of relaxing borrowing constraints, next to a possible boost to private investment. These developments lead to lower net savings and thus a lower external value of the common currency than the original strong country currency (and vice versa for weak countries’ currencies). The averaging effect naturally arises from the change in the average comparative advantage and institutional quality.

While the euro is a weaker currency than the Deutsche mark because it includes less fiscally disciplined nations, the conclusion is quite distinct from the criticism raised by some US sources of a euro exchange rate manipulated by Germany. The value of the euro is determined on international markets reflecting relative economic strength and monetary policy. The dollar was at first very low as the Fed responded to the crisis in 2008 by monetary expansion, while the euro fell after the ECB matched the Fed’s policy to alleviate deflation.

In conclusion, there is no doubt that the productive sector in countries with strong institutions benefit mightily from monetary union, precisely because its membership was so diverse in terms of institutions.

Figure 1 shows the evolution in the value of German and Dutch versus Spanish and Italian net exports since monetary union. The simple evidence shows the decline of the periphery countries and the progress in the core until the onset of the financial crisis.4

Figure 1 Net manufacturing exports (% of GDP)

Implications

A diverse monetary union is a rigid construction that has benefits and costs for both sets of countries. In difficult times, it prevents devaluation in weak countries. In a context of wage and social benefit rigidity, this will lead to unemployment and high public deficits. In a sharp downturn, only some form of cross-country transfer or implicit guarantee will avoid a sovereign default which would inevitably imply the end of the monetary union. Alternatively, political pressure for relief in weak countries may well force a breakup of a monetary straightjacket.

The notion that stronger countries gained a boost to their international competitive position while weak countries had to endure a higher (and more rigid) exchange rate offers a legitimate foundation for cross-country support in crisis periods. Weak countries would previously restore balance by a competitive devaluation (either deliberate or induced by capital flight). As in such periods, capital flows tend to target safe havens, countries with higher financial credibility would experience dramatic revaluation, as in the case of the Swiss franc.

Our institutional interpretation of a diverse monetary union is close to the content of the public debate, and identifies effects not captured by a traditional economic analysis. At times of distress, it is a natural temptation for national politicians to blame other countries. It is the job of economists to explain the general equilibrium benefits of a monetary union. A diverse monetary union has several redistributive effects, but offers its greatest benefit to production and employment in strong countries, with the indirect effect of constraining the competitiveness of producers in weaker member countries.

A redistributive policy to rebalance a redistributive monetary union

A natural channel to alleviate tension while redistributing the burden and gains from a diverse monetary union would be direct transfers. General expansionary policies are less effective as a large part may be spilled over to the rest of the world.

Fiscal transfers are invisible within a single country, but politically sensitive between countries. This is particularly true since individuals from strong countries will tend to self-attribute their relative success, while citizens of weak countries will blame their reluctance to support. To be clear, frustration with past fiscal laxitude is justified. Yet it fails to appreciate that some burden sharing compensates for the implicit monetary support provided by weak economies renouncing the adjustment allowed by devaluation. Paradoxically, the competitive gain by strong countries increases in the diversity of monetary union members. The German productive gain is proportional to fiscal laxity elsewhere.

The monetary union has complex redistributive effects. It supports producers in strong countries and savers in weak countries. It imposes a short-term cost on savers in strong countries, though it promotes the value of productive investment and thus wealth creation. The biggest loser is the tradeable sector in weak economies. Accordingly, it is unfair to blame weak employment in these countries on a poor work attitude.

In the absence of fiscal rebalancing, the burden of alleviating the redistributive tension shifts to monetary policy. A relaxed stance offers indirect relief to weak countries, but is poorly targeted. While it counterbalances the very tight monetary conditions imposed by the monetary union on weak countries, it exacerbates expansionary conditions in strong countries, currently struggling with rising house prices and mortgage credit expansion. Initially the ECB was limited to lending to banks on favourable terms. Yet as a central bank cannot assume risks, its lending requires good collateral, which is by definition scarce in weak countries. More targeted measures included a modest programme of purchases of targeted assets (the path historically chosen by the Fed) until 2011, and cross-country fiscal guarantees that strengthened the safety of sovereign debt. With the exception of Greek debt, no losses have been incurred in this coordinated relief policy.

The recent ECB quantitative easing programme has returned to purchases of sovereign debt according to its capital key, a counterproductive decision made for political reasons. Its untargeted approach has various redistributive effects. Next to the stated impact on savers and producers, now core countries experience monetary conditions that are too loose.

In order to limit spillover effects, quantitative monetary policy should target the monetary rigidity suffered by weak countries via an asymmetric purchase programme. Given the clear moral hazard consequences, quite explicit in our institutional analysis, the policy should be tied to a real transfer of spending review authority to the Eurozone countries.

Conclusions

We have outlined the redistributive effects created by the rigid structure of a monetary union next to its direct effects on monetary credibility. We highlighted the general equilibrium benefits that core countries draw from it and the cost paid by the productive sector in weaker countries. Going forward, maintaining the euro requires a fairer and long-sighted ECB policy that targets sovereign or private bonds from weaker economies, in conjunction with a grand fiscal bargain that would centralise authority over Eurozone public budgets and pension policy decisions.

Resisting this reality risks the catastrophe of a breakup. The end of the Eurozone would cause weak country citizens to lose a large part of their savings, while strong country citizens would suffer from an extreme revaluation and a much shrunken foreign market. Admittedly, old savers in these countries may have an immediate benefit from revaluation, but hardly anyone else would benefit. In any case, a sharp revaluation would ultimately undermine pension funding as well.

A superficial reading of the problem by populists leads to demands that weak countries shape up their national institutions. But all research on economic underdevelopment has shown how institutions are very persistent and cannot easily be reformed internally. Institutional change takes generations, not years. While markets adjust quickly (in terms of trade, credit pricing, or quantity), local institutions do not. This is another way to state the key mistake at the start of the euro monetary union: there was no deep institutional change in fiscal governance. As a result, political opportunism went unchecked. Yet currently most benefits of the monetary union flow to its core. Both distortions are economically and politically unsustainable.

Europe faces a clear challenge. The success of the transition to the banking union suggests that a collective effort at institutional evolution can succeed. An asymmetric monetary policy should be combined with centralisation of fiscal authority, assigning stronger and more direct powers of spending review to the EU while stopping well short of fiscal unification. Rebalancing policy choices that alleviate the monetary stricture at the periphery needs to also constrain future spending, or they would be inacceptable and even counterproductive. The discipline on weak national institutions then fully legitimises some amount of burden sharing.

The main obstacle to a serene choice on this matter is a poor recognition of the nature of deep institutional differences. While spontaneous institutional convergence is to be expected as a result if the EU, it would take a long time.5 Thus an understanding of the deeper effects of a diverse union is critical to recognising all its benefits and costs. Recognising legitimate needs and necessary changes may move us beyond destructive populist pressure driven by incomprehension of the bigger picture. While this may hardly seem the time for institutional reform, there has never been a better time.

Endnotes

[1] As Greenspan (2012) stated: "the Eurozone is confronted with a crisis of not just labour costs and prices but culture. There remains the question of whether the south would ever voluntarily adopt northern prudence."

[2] Research at the time of MU focused on its risk sharing effect in the presence of moral hazard in member state behavior, assuming cross country differences on the size of the economy or their technology (e.g. Casella 1992, Person and Tabellini 1996).

[3] Between the SME collapse in 1992 and the start of the euro a few years later, the Italian lira fell by 26% while the Deutsche mark appreciated by 16% in real terms (Persson and Tabellini 1996).

[4] Germany agreed to join the monetary union at a time of national reunification, when its average productivity fell and its trade balance suffered significantly.

[5] Note that while Eastern European institutions were strengthened by the EU, in part this reflected a return to their pre-Soviet institutional framework.

Professor of International Finance, University of Amsterdam; Research Fellow, CEPR
Enrico Perotti (PhD Finance, MIT 1990) is Professor of International Finance at the University of Amsterdam. His research in banking and corporate finance, organization theory, political economy, legal and financial history has appeared in the top economics and finance journals. He has held visiting appointments at MIT, Harvard, Oxford, Columbia Business School, London Business School, LSE and the IMF. He acted as consultant to the EC, IMF, FSB, World Bank and DNB. He was the 2011 Houblon Normal Fellow in financial stability at the Bank of England and 2015 Wim Duisenberg Fellow at the ECB. He is Fellow of the European Economic Association and Research Fellow at CEPR and Tinbergen Institute.